To "make full disclosure and play no tricks": a proposal to enhance fee transparency after Jones v. Harris Associates.

• Author: Alterbaum, Daniel S.
• Position: COMMENT

Despite the best efforts of investment professionals and regulators, retail investors often find it exceedingly confusing to choose a mutual fund. In addition to assessing a fund's performance, its suitability for achieving a given set of financial goals, and its compliance with socially responsible investing standards, an investor must consider the impact of a fund's fees on its net returns. In its guide, Invest Wisely, the U.S. Securities and Exchange Commission (SEC) lists nine types of fees that prospective shareholders should "review carefully" before making a decision. "Small differences in fees," the SEC warns, "can translate into large differences in returns over time." (1) The SEC has attempted to ease the decisionmaking process for investors by introducing fee tables, summary prospectuses, and other vehicles to disseminate the information that investors need. Nonetheless, the difficulty associated with comparing fund fees to fund performance over time has led commentators to describe the current disclosure regime as "broken and in need of reform." (2)

Nowhere is reform more sorely needed than in the realm of adviser compensation, which consists of the fees paid by a mutual fund to its investment adviser to provide managerial services. This fee is particularly ripe for abuse because the close relationship between a fund's board and its adviser may inhibit the board from negotiating vigorously for low fees. (3) Congress sought to address this problem by amending the Investment Company Act of 1940 (ICA) to include section 36(b), which imposes a fiduciary duty on advisers with respect to the fees they charge mutual funds. (4) Section 36(b) also permits shareholders to initiate actions against fund advisers for breaches of this duty, a fact that took center stage at the Supreme Court this past Term in Jones v. Harris Associates. (5) Under the rule handed down in Jones, an investor seeking to prevail in a section 36(b) action must show that his fund's adviser charged a fee "so disproportionately large that it bears no reasonable relationship to the services rendered and could not have been the product of arm's-length bargaining." (6)

Before being able to initiate section 36(b) actions, however, investors must he adequately informed about their funds' advisory fees, a consideration that the Jones opinion avoids examining altogether. Indeed, when seeking damages under a doctrine that, as Justice Alito self-consciously admitted, "may lack sharp analytical clarity" because it nebulously requires judges to consider whether "all the circumstances [of] the transaction carr[y] the earmarks of an arm's-length bargain," (7) a plaintiff-investor cannot afford to be ill-informed about the nature of his fund's advisory fees. This Comment recommends ways to augment mutual fund advisory fee disclosure requirements by including structured illustrations of fund performance and fees, as well as detailed discussions justifying recent changes in such fees. This strengthening of the disclosure requirements would support section 36(b)'s underlying purpose--to give shareholders an "effective means to restrain advisory fees" (8)--in two ways. First, shareholders would be able to make more informed investment decisions. Second, shareholders who had already invested would remain informed about the funds' advisory fees, thus making it easier to initiate a section 36(b) suit.

This Comment is divided into three Parts. Part I reviews the fee cap-and-waiver system, which allows advisers to raise their fees without promptly notifying shareholders. Part II examines the current disclosure regime and highlights relevant shortfalls. Part III recommends improvements to these disclosure requirements that would help keep shareholders adequately informed.

1. THE FEE CAP-AND-WAIVER SYSTEM

   Mutual funds require oversight to minimize conflicts of interest inherent in their structure. These funds consist of pools of money gathered from those who invest in securities. (9) The fund's "adviser," who manages its operations, is a legally distinct entity with whom the fund contracts to provide managerial services. In most cases, however, funds are organized by investment advisers, who select the fund's board of directors. The adviser draws compensation from the fund, typically as a percentage of assets under management. The ICA manages the conflict inherent in having board members, whom the adviser selects, determine an adviser's compensation. It does so by requiring that at least sixty percent of the board be comprised of independent directors (10) and by prohibiting fund transactions with affiliates. (11)

   For the same reason, the ICA also confers several voting rights on fund shareholders. For instance, shareholders must approve advisory contracts (including fees), (12) approve changes to the fund's fundamental investment policies, (13) and elect directors. (14) Congress believed that these rights would help prevent "flagrant abuses" by "giving dissatisfied stockholders sufficient opportunity to avail themselves of normal legal remedies." (15) However, shareholder voting has proved to be an ineffective means of enforcing discipline on advisory fees. (16) Some researchers have argued that voting can actually inhibit advisory-fee discipline because shareholder votes must be organized to approve the removal of an adviser, which itself is a time-consuming and costly exercise. (17) Such factors may underlie the general absence of mutual fund shareholder activism directed toward reducing advisory fees. (18)

   Specific aspects of the ICA disclosure regime further render voting ineffective for disciplining investment advisers. (19) Under section 15(a), shareholders may approve the initial advisory contract for a two-year period. (20) Subsequent approvals...